The Effects of the Demographic Transition on Economic Growth

Implications for Japan

Bachelor Thesis within Economics

Author: Marie-Lor Sundman

Supervisor: Sara Johansson

Deputy supervisor: Peter Warda

Jönköping August 2011

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Bachelor Thesis within Economics

Title: The effects of the demographic transition on economic growth: Implications for

Japan

Author: Marie-Lor Sundman

Tutors: Sara Johansson

Peter Warda

Date: August 2011

Keywords: economic growth, demographic transition, Japan, age structure, labor

supply

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Abstract

Demographic transition implies severe challenges for high income nations, for instance

Japan, as the population decreases due to declines in birth rates as well as the higher rate

of elderly population. More women are entering the labor market which affects birth

rates. In addition, technological progress has improved health care and standard of

living, bringing up life expectancies. However, the elderly population is increasing,

elevating the dependency ratio which dampens the economic growth. The changed age

structure alters the ratio of labor force negatively relative to population, in spite of the

higher female labor participation.

This paper analyzes how the current demographic transition in advanced countries

influences economic growth. The paper is focused on Japan that is currently dealing

with the consequences from the fastest increase in the percentage share of the elderly

population compared to the other high income countries. The empirical analysis is based

on a growth accounting model that estimates the impact of demographic factors on

growth rates in high income countries. The empirical results indicate that demographic

factors such as life expectancy and total dependency ratio have a negative impact on

economic growth. The conclusion is that Japan and other rich countries have to make

greater efforts in dampening the demographic change by policy making and in-

migration.

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Table of Contents

1 Introduction ............................................................................ 4 1.1 Purpose of Study .......................................................................................................... 5

1.2 Background ................................................................................................................... 6

1.3 Previous Studies ............................................................................................................ 6

2 Theoretical Framework ......................................................... 9 2.1 Demographic Transition ............................................................................................. 9

2.2 Growth Theory ........................................................................................................... 10

3 Data and Statistical Method .................................................... 15

4 Empirical Results and Analysis .............................................. 18

5 Summary and Concluding Remarks ....................................... 21

6 Appendices ............................................................................ 22 Appendix 1 .............................................................................................................................. 22

Appendix 2 .............................................................................................................................. 23

Appendix 3 .............................................................................................................................. 24

Appendix 4 .............................................................................................................................. 25

References ...................................................................................... 26

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1 Introduction

The world economy is currently facing a great challenge as the rate of the elderly

population increases while birth rates decrease. This development results in a reversed

population pyramid in which the amount of young people is not enough to support the

elderly. Since the Second World War, developing countries have experienced highly

changed rates of mortality and fertility. During the past fifteen years, population

growth rates have been decreasing for almost all OECD countries. In fact, all OECD

countries will probably face much slower population growth if not the birth rates or

immigration from non-OECD countries increase (Hagemann & Nicoletti, 1989).

Countries such as Germany, USA, Japan and Sweden are recurring essential examples

of the reversed population pyramid in studies of demographic change. The country

that sticks out the most is Japan. The nation is one of the biggest economies in the

world and is in a recession since 2008. As the country is trying to cope with the

recession, the economy is also struggling with the demographic change.

The Japanese population has the highest life expectancy in the world raising the

numbers of elderly, implying a rise in health expenditure as well as costs in pension

and social security programs. The pace of the Japanese aging is extremely high. The

extended life expectancies have created an aging problem for Japan where the amount

of elderly is excessively large. In other words, the working-age share will fall as the

birth rates decline and the elderly population increases. The changed age structure has

a significant effect on economic growth as it alters the demand for workers. The

question is how sustainable the economic growth is when facing a rising number of

elderly leading to an increasing dependency ratio. Currently, the small working-age

share is dependent by the elderly who rely on the support of health care institutions

and social security (Bloom et al., 2001).

Caused by the falling birth rates, the Japanese population of 127.5 million is estimated

to diminish to 95 million people by 2050. In the same year, the population of 65 years

and above is predicted to rise by 20 percentage points. This means that for every 2

worker one person is retired. In addition, the Japanese immigration policy is heavily

restricted which explains the low immigration rate. As a result, this generates

difficulties for workers as they share the burden of supporting the elderly.

Consequently, Japan will deal with one of the most severe demographic

circumstances in the industrialized world, if not a rise in the birth rates or the

immigration rates from other nations increases (Bloom et al., 2001).

The thesis is structured as follows. First, the theories and results from previous

research are stated to provide a deeper understanding of the effects of demographic

change on economic growth, in the perspective of the Japanese economy. In the

second section, theoretical framework is presented along with the empirical model

applied in the study. The third section presents the data together with the method. In

Section 4, the result is given in the purpose of projecting the demographic transition’s

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effects on the economic growth including the analysis. The last section contains the

conclusion of the demographic factors altering the Japanese economy as well as the

economies of high income nations.

1.1 Purpose of Study

The purpose of the thesis is to examine how demographic transition affects economic

growth with the Japanese economy as an extreme example. Econometric estimates of

a growth accounting model, including demographic factors, are used to discuss the

effect of demographic change on the growth rate of the economy. The growth

accounting framework of this paper is based on endogenous growth theory and is

extended with the demographic transition as an additional factor explaining cross-

country variations in economic growth. The method of estimating the effect of the

demographic transition is to make a regression analysis on cross-country data using

the ordinary least squares estimation method.

1.2 Background

Most OECD countries have faced low birth rates in combination with higher rates of

the elderly population, which have led to a diminishing population growth rate and

rapidly changing age compositions. Keynes (1937) predicted that decreasing

population growth affects aggregate demand and output growth negatively (see also

Hansen, 1939, and Myrdal, 1940). Previous research has shown that population aging

will affect the structure of industrialized economies through its impacts on labor

markets, demand, savings rate and capital accumulation (Hagemann & Nicoletti,

1989).

The age structure of the population has a large impact on the economy. The economic

behavior of the population changes at different life stages. If the majority of a

country’s people are in the working-age population, the extra productivity rate would

lead to economic growth. If most of the population is elderly, many resources are

required for the less productive, resulting in a slowdown of economic growth. What

alters the economic growth is the different behavior of the population, considering

that every age group invests and saves differently. Young people invest more in

health and education, while the prime-age adults supply labor and savings as the

elderly necessitate health care and retirement income. The working-age population

has a higher level of economic output and savings than young as well as old people,

who consume more than they produce (Bloom, et al., 2001).

About 10 percent of the world population is aged above 60 years. This rate is

estimated to increase more than 20 percent by 2050. People who are 85 and over will

increase the fastest. Today, the world is moving from a large amount of young people

towards a population in which many are above the age of 65, implying less young

people will be able to support the old population. (Pollack, 2005) This is illustrated in

the three population pyramids of year 1950, 2000 and 2050 in Appendix 4.

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At the moment, the population of Japan is expected to live until 81 years. In 1920, the

median age1 of a Japanese person was 27 years. At recent time, that median age

increased to over 40 years. The fertility rates of only 1.3 children per woman together

with the high life expectancy rate and the increasing of the elderly bring huge

consequences to the Japanese economy. In addition, the rapid increase of the retired

population leads to a higher dependency ratio2. This brings increased costs in terms of

health, pension and social security for the economy (Bloom, et al., 2001).

Japan’s speed of population aging was below the OECD level in the 1960s, but is

estimated to become amongst the highest in the organization by 2025. This

distinguishes Japan from the other countries that are experiencing the demographic

change as well. The rising life expectancy in Japan creates a new definition of the

elderly. In 1990, the limit of the elderly population was people aged 67 or above. In

2025, the definition of the elderly will be at the age 70 or over. In history, no

population has ever aged this much and rapidly (Hurd & Yashiro, 1996).

The raised economic insecurity due to the financial crisis has elevated the pressure on

the Japanese workers. This fact, among other reasons, has led to a delayed marriage

age since people do not have time to spend on families. In turn, it has resulted in

decreasing fertility rates. Moreover, the fall in the housewife rate due to the enhanced

lack of enthusiasm several young women have for the traditional housewife role, is

the result of their willingness to capture the labor market opportunities (Yashiro,

1998).

1.3 Previous Studies

Previous models applied to find the economic effects of population aging have made

different conclusions due to different usage of variables such as capital profitability,

endogenous technological change and labor supply in response to aging.

The IMF Multi-Country Macroeconomic Model, applied by Masson and Tryon

(1990) was used on seven major OECD countries. The conclusion of the changed age

structure was the decline of the labor force results in the decline of capital stock and

potential output; the decline of the savings rate stimulates the consumption

expenditure; the increase in government expenditure expands the aggregate demand;

share in GNP of the private saving and gross private investment fall, leading to the net

external surplus decline. The Japanese private saving was found to decrease by 4.3

percent during 1995-2025 as the gross private investment declines by 1.8 percent.

This Keynesian-type model explains the relation between countries with diverse aging

rates, but assumes no adjustments in the labor force participation rate and no

technological transitions. The model is Keynesian due to its conclusion that the rise in

government expenditure results in an increased aggregate demand (Hurd & Yashiro,

1996).

1 The age that is in the middle of the young aged and the elderly aged population 2 The ratio of population aged 0-14 and 65+ years

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Using a neoclassical model, Noguchi (1990) found that the capital return declines

with decreasing labor force rate. Also, the household savings rate decreases as the

proportion of the elderly in the total population increases since individuals save while

they are employed and not save after retirement. The savings rate has a negative

relationship to the old-age dependency ratio3. Additionally, the high household

savings have contributed to a Japanese economic growth. Thus, as the old-age

dependency ratio increases, the economic growth is dampened. According to a cross-

sectional analysis of the relationship between savings rate and the old-age dependency

ratio in OECD countries in the 1980s, Japan’s current household savings rate has been

estimated to fall by more than one-half in response to the estimated doubling of the

old-age dependency ratio. However, Noguchi did not consider labor supply responses

to population aging when analyzing through the model. According to him, the

Japanese current account surplus was estimated to stay unchanged through 1990s, to

increase in 2000-2010 and to decrease in 2010 and later (Hurd & Yashiro, 1996).

Auerbach et al. (1989) applied the Overlapping Generations Model on Germany,

Japan, Sweden and the United States. The model concluded that the increasing rate of

elderly population will lead to a general decline in the savings rate. The speed of the

decline will be faster in Japan and will approach 0 in 2025, when the ratio of elderly

to the total population arrives to a platform. Assuming an “open economy” (the

perfect international capital mobility), the increase in capital-labor ratio coming from

the rapid demographic shift in Japan results in a capital outflow for the purpose of

preserving the preexisting return on capital. This will increase the current account

surplus. The decline in labor supply reduces the investment proportionally and will

therefore not lead to a decline in the current account (Hurd & Yashiro, 1996).

Economic Planning Agency (1991) proved with the Turnpike “optimal growth”

model that the national savings rate and the aggregate investment will decrease in

Japan. In addition, the labor efficiency will develop with increasing labor scarcity,

especially in the service sector, where relative labor productivity is mostly low. In

turn, the current external balance will become a deficit after year 2000. The decline in

the labor force will result in a decreasing rate of economic growth. This was based on

the assumption of free mobility of labor across industries (Hurd & Yashiro, 1996).

By using the Cobb-Douglas function and neoclassical factors, IIASA4 applied the

Economic-Demographic Simulation Model in 1992. The conclusion was that the

Japanese demographic transition slows down the growth of GDP per capita and the

savings rate, while raising the expenditure on social security, assuming no change in

labor force participation rates or pension-, health-, and long-term care benefit

calculations. According to IIASA, the disposable income of the elderly and the

working-age population are estimated to increase, i.e. the living standards will

progress. Nevertheless, the living standards of the young relative to those of the

elderly will worsen the most. Due to the changed age structure, the declining savings

3 The amount of the population aged 65 years and above divided by the population aged 15-64 years 4 International Institute for Applied Systems Analysis

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rate will give implications for Japan and also the world economy (Ermolieva, et al.,

2003)

Bloom (2009) and Finlay (2009) applied a growth accounting framework connecting

the working-age share with economic growth. By estimating factors contributing to

the demographic change, such as life expectancy and working-age population growth

they could forecast the negative effects on economic growth in the future. They

concluded that Japan among other countries will meet economic challenges in the

future if they do not support the working-age population by increasing the in-

migration from other countries.

The previous studies show that the national savings rate, the investment rate and

output fall as population ages. The relative speed of aging is critical in determining

the future path of the economy. As the structures and assumptions of the models

differ, the differences in the projections of the saving, investment, and output depend

on the extent to which these models account for feedback effects of demographic

shifts. The effects of the increase in the elderly population influence the changes in

the labor productivity, saving and investment. The associated decline in growth rate

of labor force is important to look upon when estimating the economic performance.

Previous studies have assumed that the labor force participation and technological

change are independent of population aging; thus the outcomes have shown negative

effects on Japan’s currently high savings and investment rate. As the labor supply

declines while the fertility rate does likewise, more rapid technological change may

be stimulated and moderately counterbalance the negative impact of population aging

on savings and investment. Therefore, using the labor supply and technological

change factors as endogenous instead of exogenous will modify the projections of

savings and investment patterns (Hurd & Yashiro, 1996).

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2 Theoretical Framework

Thompson (1929) developed a model of demographic transition which explained

stages of different birth and mortality rates in order to demonstrate how the economy

affects the demographic transformation. Solow (1956) specified the neoclassical

growth model showing how labor, capital and technology influence economic growth.

Models of the new growth theory have extended Solow’s idea by assuming

endogenous growth in different factors of production. In order to understand how

demography affects economic growth, these theories are presented below.

2.1 Demographic Transition

The formation of a population and its labor force is due to demographic factors such

as birth rates, death rates and the age structure influencing the number of workers.

The current demographic change is affecting economies in the sense that labor supply

diminishes as the population pyramid turn from a small share of the elderly and a

large amount of the young to the extreme opposite of that structure. The

transformation of the population pyramid, from year 1950 to 2050, can be found in

Appendix 4.

In theory, the demographic transition takes place when countries develop from an

establishment of the first stage, high fertility and mortality to the last stage, low

fertility and mortality. Currently, Japan as well as USA and Sweden are in the last

stage. There are several main reasons for the demographic change in the countries.

Technological improvements have enhanced the health care which has reduced the

death rates. In addition, the female labor participation is increasing as countries

become more modernized which brings consequences for family sizes. For

industrialized countries, having children implies more costs, i.e. higher incomes result

in lower birth rates (Kirk, 1996).

The demographic transition model is based on five stages. The first is the pre-

industrial or the high stationary phase. This stage is characterized for its high birth

rates and high death rates that are in balance. The population is living in an

agricultural community where many infants are born and diseases are spread. The

second stage is the developing or the early expanding phase of the demographic

change. High birth rates and high death rates of the “high stationary” level are

present, although the death rates fall more than in the first phase. Agricultural

methods and food supply are improved, including crop rotation, selective breeding,

and seed drill technology. In addition, public health is enhanced, reducing the

mortality rate, especially in infancy. Moreover, industries such as machines, transport

by road and rail have progressed. The third stage is distinguished by its urbanization

and is the late expanding phase. Urbanization alters the traditional values for families;

hence, the rising costs of having children and the higher female employment. The

birth rates and death rates are now declining, yet the death rates are lower than the

birth rates, bringing annual population growth. The fourth stage is the industrialized

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and low stationary phase in which there are low birth rates and low death rates.

Lastly, the fifth stage is the post-industrialized and declining phase implying excess

death rates over birth rates unless increasing immigration occurs. Especially Japan

and numerous European countries are experiencing the last stage of the demographic

transition (Blacker, 1947).

When Thompson (1929) specified the demographic transition theory, he also defined

three types of industrialized countries in which the shift of population growth rates

differed. The first country, called A, was experiencing a population decline due to a

fast fertility decrease and a low mortality. For the second country, B, birth rates and

death rates had dropped. However, the death rates declined earlier and faster than

birth rates. This lead to a population growth until it was offset by falling birth rates

and afterwards decline. In the third country, C, the birth rates or death rates change in

an uncontrolled manner, hence, the population growth would fall. Thompson found

that Japan among the other countries he analyzed would face a demographic change

like in category C and it would take 30-40 years, i.e. around the 1970s, until it became

a country within category B. Already when the demographic transition theory was

stated, Thompson warned about the consequences arising due to the economic

demographic transformation (Kirk, 1996).

2.2 Growth Theory

Solow’s neoclassical growth theory describes how various factors of production such

as capital and labor affect growth in total output and how the accumulation of

production factors and increased productivity lead to a steady economic growth. To

understand the new growth theory and the structure of the model used in this paper,

one has to apprehend the growth model and the growth accounting that Solow

introduced. Solow’s growth model presents the steady-state equilibrium that will be

eventually reached through variations in capital and labor. The steady-state

equilibrium occurs when the economy is following a balanced growth path, implying

that growth rates of output and capital are constant, and the economy stay in this state.

The capital and labor adjust in order to keep the equilibrium when new technology

enters the country. In other words, economic growth continues only when technology

advances. At steady-state equilibrium the investment required to provide capital for

new workers and substitute worn-out machines is equal to the saving of the economy.

That is, the growth of the ratio of capital to population is dependent on savings after

depreciation and supply of capital per worker to new workers entering the labor force,

with the assumption of constant technological progress. The change in the ratio of

capital to population has a positive effect on saving per capita and a negative effect on

growth of labor per capita (Todaro & Smith, 2008). A high savings rate leads the

economy to a balanced growth path with the property that there exist possible

alternatives involving higher consumption at every period (Romer, 2006). If savings

exceeds the investment requirement, output will increase as capital per capita

increases. If the savings rate is less than the investment requirement output will fall.

When capital per capita is less than the steady-state value of capital per capita, and

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income less than the steady-state value, capital accumulation will eventually move the

economy to the steady-state values (Dornbusch, et al., 2008).

Solow’s model is based on a general production function, Y = AF (K, L), which

shows the relationship between output and input. Output (Y) rises as the capital stock

(K) increases and also through increases in productivity (A) due to technology

improvements and a higher labor force stock (L). Thus, the marginal product of labor

(MPL) and the marginal product of capital (MPK) are positive. The production

function can be used to derive the growth accounting equation. With the growth

accounting equation, one can find how large extent capital and productivity attributes

to economic growth, assuming diminishing returns to capital and labor.

[

] (

) (

) (1)

In Equation (1), is the growth rate of output, is the labor share, is the

capital share, is the growth rate of labor, is the growth rate of capital,

and is the technological progress (Dornbusch, et al., 2008). With the equation,

we can obtain information of how much growth over a time period is due to increases

in diverse factors of production and how much comes from other factors.

Growth models show that economic growth comes from one or more factors which

are the following: growth in labor quantity and quality (through population growth

and education), capital growth (through saving and investment); and technology

improvements. Policy making is essential for economic growth as it can promote

saving and investment among other factors. Also, by opening up a market of an

economy will attract even more domestic and foreign investment, which increases the

capital accumulation and economic growth. Population growth can either have a

positive or negative effect on the economy. An increase in population growth rate,

through for example immigration, can enhance output per capita as more workers are

entering the workforce. This depends on how well the economic system incorporates

and productively employs the additional workers, a skill connected to the rate of

capital accumulation and the availability of associated factors, for instance managerial

and administrative skills (Todaro & Smith, 2008).

New growth theory, also known as endogenous growth theory, states that growth is

determined by the system ruling the production process instead of forces outside that

system. The theory assumes that investments in human capital lead to external

economies of scale and productivity improvements. In contrast of the neoclassical

assumption of diminishing marginal returns to capital investments, there exist

increasing returns to scale in aggregate production. Endogenous growth models

emphasize the importance of public policy in encouraging economic development by

investments in human capital and promotion of investment in knowledge-intensive

industries, for instance computer software and telecommunications (Todaro & Smith,

2008).

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The Ramsey-Cass-Koopman’s model and the Diamond model are similar to Solow’s

growth model in the sense that they take into account the growth rates of labor and

technological progress which also refers to advances in knowledge. Nonetheless, they

differ in the dynamics of economic aggregates since they are established by policies at

the microeconomic level. The models derive the development of capital stock from

the maximization of households and firms in competitive markets, leading to an

endogenous savings rate. These models treat saving as endogenous and time-varying

and they are constructed from individuals’ behaviors. Since welfare depends on

consumption (not output), the models can be used to discuss welfare issues (Romer,

2006).

The Ramsey-Cass-Koopman’s model assumes that competitive firms rent capital, hire

labor to produce and sell output. In addition to the existence of competitive firms,

there is a fixed and infinite amount of households that supply labor, hold capital,

consume and save. Firms maximize profits and are owned by households, meaning

that any profit accumulates to the households. The economy depends on the behavior

of households and firms. Firms employ stocks of capital and labor, pay marginal

products and sell the output. Since firms are competitive, they earn their marginal

product. Households want to maximize their life-time utility by dividing their

incomes (from supplying labor and capital as well as the profit they earn from firms)

between consumption and saving at each point in time. Households’ utility also

depends on the amount they work. This distinguishes the Ramsey-Cass-Koopman’s

model from Solow’s model as saving is derived from the behavior of households

while there exist no externalities, implying that saving is not constant along the

transition to the steady-state equilibrium. There cannot be an equilibrium in which the

economy follows a path and reaches a higher consumption level for every time

period. Since households value current consumption more than future consumption,

the advantage of the permanent increase in consumption is restricted. What influence

households’ preferences between current and future consumption is the interest rate.

If the interest rate decreases, the savings rate increases. When analyzing the behavior

of households, one has to first specify whether the decline in the interest rate was

expected or unexpected. Households optimize their utility, dividing the output

between consumption and investment, while they believe the interest rate will be

unchanged. At some point, the households realize that the preferences have been

altered and now lower the future rate of utility (Romer, 2006).

The Diamond Overlapping Generations Model is similar to the Ramsey-Cass-

Koopman’s model, but differs in the assumption of the population. According to the

Diamond model, new households are continuously entering the economy. New

individuals are frequently born while old individuals are dying. The individuals have

different behavior in two time periods, as young-aged and old-aged. While the young

supply one unit of labor dividing it into consumption and saving, the old consume

savings and any interest they earn. If an individual’s consumption is increasing or

decreasing over time depends on whether the real rate of return is higher or lower than

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the real interest rate. A rise in the real rate of return implies that the second-period

consumption is now more favorable which tends to increase saving, but an amount of

saving that gives more second-period consumption decreases saving. As the

assumptions in the Ramsey-Cass-Koopman’s model, there are competitive firms with

constant returns to scale and technology grows exogenously. In addition, the real

interest rate is equal to the marginal product of capital, since capital earns its marginal

product due to competitive markets. Since it is assumed that there is no depreciation,

the wage per unit of effective labor is labor’s marginal product multiplied by capital

per unit of effective labor (Romer, 2006).

Growth models including human capital and Research & Development (R&D)

assume endogenous growth of productivity since they highlight investment to

knowledge or technological progress. The effectiveness of labor represents

knowledge or technology which explains why more output can be produced today.

Romer (1990), Grossman and Helpman (1991), Aghion and Howitt (1992) developed

growth models including R&D. Their models contain two sectors, a goods-producing

sector where output is produced and a R&D sector where the stock of knowledge

grows. The general production function still contains the combination of labor, capital

and technology (or knowledge) in order to improve technology, capturing the idea of

devoting more resources to research will lead to more innovations. Knowledge is not

assumed to have constant returns to scale to capital and labor, i.e. doubling inputs as

output doubles, implying that the new inputs can do the same as if the old inputs were

doubled. With constant returns to scale, the same innovations would be made twice;

thereby there is a possibility of diminishing returns in R&D. On the other hand,

cooperation between researchers, fixed setup costs etc. might be essential enough for

R&D to double capital and labor more than doubling output. In that way there is a

possibility of increasing returns in R&D. Population growth increases with growth of

knowledge, as the population increases more innovations can be made. New

innovations are not created exogenously, but by the population. That is, the long-run

growth rate of output per capita is increasing with the rate of population growth. The

growth of knowledge can be the source of a higher output and standards of living

today than earlier time periods (Romer, 2006).

The standard growth accounting function implies that the change in technological

progress does not affect the balance of capital and labor. Mankiw, Romer, and Weil

(1992) agreed with Solow that the long-run steady state, the level of output per capita

should be positively correlated with the savings rate. They developed an augmented

version of the Solow model by adding human capital as a third factor in the growth

accounting function. The augmented Solow model provides a better description of

cross-country data, according to MRW. Ever since this discovery, many authors have

applied the MRW model to make research on the significance of additional growth

variables. The MRW model has been very applicable as there have been many cases

where the unexpected growth performance of countries are not explained by

technological progress, but by factor accumulation (Aghion, et al., 2009). The main

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focus of the MRW model is on the accumulation of human capital (education), not the

human capital stock. Human capital represents the amount of productive services

supplied by workers, i.e. the contribution of different skill levels to production. The

contribution contains of raw labor (skills that individuals are provided with) and

human capital (obtained skills). Every worker’s human capital depends on his or her

time of education. The more education workers have the more human capital. In

addition, as individuals obtain human capital, the ability of obtaining more human

capital can improve. For example, individuals learn basic knowledge, such as reading

and writing, during the first years of education which do not contribute to growth in

output by themselves. However, they are important for attaining additional human

capital (Romer, 2006).

The model of this paper is based on new growth theory that takes into account the

endogenous savings rate altered by the behavior of different age-groups of a

population as in the Diamond model. As the population growth rate is falling, the

labor supply decreases while the effectiveness of labor decline as older workers

increase. Since the declining young population invests in education, there will be less

investment in human capital. Fewer people will graduate a higher education as the

economy pressures the population to enter the job market as soon as possible. This

also contributes to lower effective labor, which we can learn from the models

including human capital and R&D. Technological progress has improved the

standards of living which has extended the life expectancy of the population, raising

the amount of the old-age population. As a consequence, household savings fall

causing the economic growth to go in the same direction since the elderly spend their

savings. In summary, the model of this paper focuses on the effect of the increasing

second-period age-group (Hurd & Yashiro, 1996).

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3 Data and Statistical Method

This section presents the regression model, a description of how the cross-sectional

data was collected and has been computed to measure the impact of growth rates.

3.1 Data and Method

The data for the regression analysis and the definitions of the variables were taken

from World Bank Development Indicators (World Bank, 2010). One of the

demographic data: total dependency ratio, was taken from World Population

Prospects (United Nations, 2009). Some data for a few countries were not available,

which is the explanation why the test included 52 out of 60 observations. The number

of 60 was chosen as sample size since it would give a general image of economic

growth affected by demographic factors. The observations were chosen by taking the

60 richest countries judged on their GDP levels. The reason was to look upon

countries that were most similar to Japan. The variables are given in growth rates

during 10 years and per capita terms. Previous studies have done cross-country

comparisons in per worker terms, focusing on the performance of companies on

output per worker. This paper investigates the economy as a whole. When

emphasizing the savings rate based on endogenous growth theory as this paper does,

output per capita behaves similarly as output per worker (Romer, 2006). We are

interested in the demographic effects on economic growth for all inhabitants of a

country; thus the data is stated in per capita terms (Dornbusch, 2008). The method of

forecasting the effect of the demographic change on the industrialized economy is to

make a regression analysis on cross-country data using ordinary least squares and

estimate the elasticity of each variable affecting GDP per capita. Adding two

demographic variables, life expectancy and total dependency ratio into a growth

accounting equation based on the neoclassical growth framework, the outcome of the

demographic transition on economic growth is estimated. The demographic transition

as a factor of economic growth has not been discussed much since numerous growth

models include other common variables such as human capital and technological

progress. Comparisons can be drawn to this paper with previous research made by

Bloom and Finlay (2009), as they highlight the working-age share and include other

demographic factors such as dependency ratio and life expectancy. They combine the

two dependent age-categories, the young and the elderly into one variable: total

dependency ratio. This paper focuses on the latter variables more since they provide

the same outcome, i.e. the result of the changed age structure on economic growth.

3.2 Model specification

The following growth model was applied in the regression analysis and shows

relationship between the natural log of GDP per capita as dependent variable and the

log of capital per capita, labor per capita, total dependency ratio and life expectancy:

16

((

)

(

)

) ((

)

(

)

) + (

) + (

) + Life expectancy99

The complete regression model becomes:

ln(GDP/Cap) = β0 + β1 ln(Capital/Cap) + β2 ln(Labor/Cap) + β3 (Dependency ratio) + β4(Life

expectancy) + ε

where signifies the change in 10 years, from base year 1999 to current year 2009,

and ε is the error term. GDP per capita, ln(GDP/Cap), capital per capita

ln(Capital/Cap) and labor per capita, ln(Labor/Cap), were log differenced in order to

make them as growth rates, since the rates of change of its natural log are equal to the

growth rates of the variables. Only the difference in the total dependency ratio

(Dependency ratio) was calculated. Life expectancy at birth (Life expectancy) was

applied as a variable stating the number of years, based on year 1999. The summary

containing definitions of the variables are explained in Table 3.1.

In this paper, GDP per capita is simply the growth rate of the economy. Capital per

capita needed to be calculated since there are no available data of that kind. By taking

the sum of gross capital formation in constant local currency unit (LCU) for 30 years,

one can achieve an approximate measure of the capital stock. The gross capital

formation (constant LCU) is adjusted for inflation. For capital in 2009, gross capital

formation was summed from time period 1979-2009, and for capital in 1999, the sum

derived from period 1969-1999. Dividing these capital values with the population

rate, capital per capita was obtained for both 1999 and 2009. Labor per capita was

calculated by taking the total labor force divided by the population rate. The variable

of labor per capita represents the people who are economically active, aged 15 years

and above. This includes the employed and the unemployed. The size of labor force

depends partly on the amount of females who prioritize the career before families.

Capital per capita together with labor per capita out of the growth model influence

GDP per capita the most, and show the factors of production per head in a country

(Dornbusch, et al., 2008).

To attain the change in the total dependency ratio (Dependency ratio), the difference

between the value for 1999 and the value for 2009 was taken since the ratio is already

in a percentage. The variable signifies the amount of the population aged 14 and

below as well as the population aged 65 and above divided by the working-age

population. In other words, the share stands for the amount of people being dependent

on the work force. Total dependency ratio was chosen since it takes into account the

(low) fertility rates as well as the (increased) aging population. Bloom and Finlay

(2009) assumed homogeneity in the two dependent age-groups when they ran their

regression analysis while this paper includes these groups as one variable. These age-

groups do not contribute to growth in output as the old-aged retire and the young-aged

are learning basic knowledge that does not add to human capital. However, the basic

education is important for obtaining additional human capital (Romer, 2006).

17

Life expectancy at birth (Life expectancy) was handled as a level variable in base year

1999, i.e. the number of years in life expectancy. The definition is the average number

of years an infant is expected to live if the current trends of mortality at that year of its

birth were constant during its existence. Bloom and Finlay (2009) used life

expectancy as level variable since the measurement in number of years would be

appropriate in the regression analysis. The choice of the two demographic variables,

dependency ratio and life expectancy, was based on the research made by Hurd and

Yashiro (1996). They stated that these factors together foster population aging, which

affects the labor force. That is, dependency ratio or life expectancy does not raise the

population aging alone.

The growth rates of labor per capita and capital per capita are expected to have a

positive correlation with the growth rate of GDP per capita in the regression analysis.

In contrast, the growth rate of the dependency ratio and the average level of life

expectancy are expected to have a negative relationship with the growth rate of GDP

per capita.

Table 3.1 Definition of the Variables.

Variable Definition

Relation to the

dependent variable

lngdp_per_cap Log of growth in GDP per capita, %

ln(GDP/Cap) Annual change in GDP per person during 10 years

lnk_per_cap Log of growth in capital per capita, % Positive

ln(Capital/Cap) Annual change in capital stock to a country's population during 10

years

lnl_per_cap Log of growth in labor per capita, % Positive

ln(Labor/Cap) Annual change in labor force to a country's population during 10

years

Dep Growth in total dependency ratio, % Negative

(Dependency ratio) Annual change in the rate of dependents on the working-age

population during 10 years

life_exp Life expectancy at birth, years Negative

(Life expectancy) Expected life time for newborn if the mortality pattern was constant

at its birth year

18

4 Empirical Results and Analysis

This section gives an overview of the regression results as well as an interpretation of

the values from the regression test.

4.1 Regression Results

The exogenous variables for capital per capita, total dependency ratio and life

expectancy are all significant in the model. Their p-values are below the significance

level of 5 % which is shown in Table 4.1. Capital per capita has a positive impact on

economic growth while the demographic variables have negative effects as expected.

The variable for labor per capita is insignificant; thus, this variable is not discussed in

this section.

Table 4.1 Regresson results. Dependent variable: Ln(GDP per capita)

Variable Regression

coefficient T-statistic P-value

ln(Cap/Cap) 0.133299* 2.288735 0.0266

ln(Labor/Cap) -0.710825 -1.61492 0.113

(Dependency ratio) -1.161887* -3.01841 0.0041

(Life expectancy) -0.011302* -3.8185 0.0004 R-squared: 0.536025., Adjusted R-squared: 0.496538., # of observations: 60

* Significant at the 5% level

The coefficient of capital per capita shows that if the growth rate increases, GDP per

capita will increase. If growth in dependency ratio or the level of life expectancy

rises, GDP per capita will decrease. The complete regression results and correlation

matrix are shown in Table 6.2 and Table 6.3 in Appendix 2.

4.2 Analysis

The result of the regression analysis has affirmed that the current demographic change

slows down economic growth. The coefficients of the demographic variables

evidently show the negative impact that life expectancy and total dependency ratio

have on growth in GDP per capita. Analyzing the scatter plots, Figures 7.1 in

Appendix 3, one can observe the linkages of demographic factors and growth. In

addition, it is shown that the high income countries share similar problem since many

plots are close to each other. Japan, denoted by the colored plots, has the highest life

expectancy and total dependency ratios contributing to a much lower labor force. The

increased aging of the population has created increased costs in health care, retirement

incomes and social security programs which explain the slowdown of the growth rate

in capital per capita. The growth rate of capital per capita for Japan is not impressive,

but is similar to the other countries’. One can discover that the demographic transition

has hit Japan the hardest, but the other countries are not far away. These results are

supported by previous studies made by Bloom and Finlay (2009).

19

The regression results show that labor per capita has an insignificant relationship to

economic growth. Also, the regression results demonstrate the negative relationship

between labor per capita and the dependency ratio, i.e. an increase in the population

growth leads to a lower economic growth. This outcome is probably due to

multicollinearity between labor per capita and the dependency ratio. In line with the

neoclassical growth theory, a decreasing population growth rate, hence the decline in

labor force, gives a negative effect on economic growth. However, the labor force is

less essential than the skills and talents of workers, i.e. the effective labor, which can

be explained by the growth theory. Investment in human capital, such as education

and on-the-job training, is important since it increases the stock of skills, in the same

way physical investment leads to physical capital. In other terms, labor productivity is

more important than the size of the labor force (Dornbusch, et al., 2008). Thus,

economic growth can still be sustained although a declining population. In addition,

as the labor force has declined since the fertility rate has fallen, the aging population

has increased and the life expectancy has extended, thanks to improved technological

progress in medical services. The negative relationship between higher life

expectancy and economic growth was proven in the regression analysis (see Table 6.2

in Appendix 2). One should keep in mind that Japan together with several other

countries are in the last stage, the declining phase, and lies in category B of the

demographic transition model, i.e. falling birth rates as well as death rates leading to a

population decline. The low birth rate is due to the fact of having children implies

higher opportunity costs for women entering the labor force. What distinguishes

Japan from the other countries in the same stage is the women’s strict choice of

working or not working. In Japan, the women have to choose between being a full-

time housewife and making a career. If the Japanese government minimized these

opportunity costs by promoting child-care services or jobs for women with children, it

could neutralize the country’s low birth rate (Yashiro, 1998).

However, the amount of workers is decreasing tremendously even though there are

more females participating in the labor force. The decline of the labor force has

lowered GDP per capita, according to statistical data from World Bank. The growth

rate of the Japanese labor is the second lowest rate of the 60 richest countries (see

Figures 6.1 in Appendix 3). The decline of population does not only decrease the

labor supply, but also the level of labor productivity. This affects economic growth

negatively because of the lower average quality of labor force due to the increasing

amount of older workers (Hurd & Yashiro, 1996).

The large population of Japan has been a main contributor to its qualified labor force

and for the economic growth of the country. On the other hand, there are rich

countries with a small population for example the Scandinavian countries. The

demographic issues are not based on the population sizes, but the course of the

diminishing population rate. Japan has been accustomed to its great population size

for a long time; thus dramatic changes in demography, from low to high dependency

ratio, will shock the economy. The raised economic insecurity due to the financial

20

crisis has elevated the pressure on the workers in terms of more labor hours. As the

aged population rises, the working-age population is already pressured in the hectic

working conditions such as more overtime work. Both the government and families

will have a challenge in supporting the aged population. The working-age population

will face lower income, higher taxes and social security contributions in the near

future (Yashiro, 1998).

In order to dampen the negative effect on economic growth, the governments of the

high income nations have to endorse immigration. The Japanese government must

specifically encourage saving in addition to increasing the working-age population

through immigration. Raising the normal retirement age might increase the labor

force from the 65+ population, but is not the best long run option for the countries.

Further implications for policy makers arise when trying to increase the fertility rates.

The consequence of increasing the fertility rates will be a lower female labor force

participation which could also hinder the economic growth. Promoting immigration

seems like the only option to avoid a demographic economic crisis in the future

(Bloom, et al., 2009).

Keeping in mind the new growth models, the demographic change has huge impacts

on the economy. The demographic transition is responsible for the decline of labor

per capita as the population rate decreases; the decrease in capital per capita due to the

excess of elderly bringing costs for the countries; and the fall in savings per capita for

a long period as the dependency ratio and life expectancy increase. Economic growth

will be affected by the change in economic behavior of the population as the rapidly

increasing elderly save less than the working-age population. The decreasing savings

rate brings a decline in GDP per capita until a new steady-state is reached. How long

the process of attaining the equilibrium is up to the governments when making

policies that support the economy.

21

5 Summary and Concluding Remarks This paper has highlighted the issues of demography affecting economic growth. The

regression results have proven that the demographic transition has negative impacts

on GDP per capita. As Thompson predicted with the demographic transition model,

the higher income a country earns, the less new infants are born. This statement is

supported by the conclusion that Japan as well as other high income countries are in

the declining and post-industrialized phase. Additionally, as technological progress

impacts the standard of living and health care, the higher life expectancies generate

more old-aged people. With the new growth models, one can find that the

demographic transition affects the growth rates of capital per capita and labor per

capita negatively. This is due to the decreasing population rate and the rising costs of

the increasing elderly that spend their saving. Consequently, the working-age

population must deal with a higher pressure at work, lower income, higher taxes and

social security contributions to support the elderly.

Yashiro (1998) stated that Japan is in a situation in which elderly labor force

participation rates are higher and more discouraged workers are entered into the job

market. Even though, more people are entering the labor force, it has already begun to

fall, holding the labor force participation rates constant. There is an increased rate of

female participating in the labor force; among those are unmotivated workers who

feel they cannot work as well as those who put their career before making a family.

This will lead to a lower quality of the labor productivity. A possible solution to

stabilize the birth rate is to reduce the opportunity costs for females, for example by

raising child-care services or providing work for the women who are over the age of

bringing up a child.

The future of high income countries looks critical since the demographic changes are

unavoidable. If some governments do not involve in demographic issues, the arising

consequences for the economies will be severe. The Japanese government needs to

consider increasing in-migrating population immediately. If not, the Japanese

population rate is predicted to fall by around 75 % in 2050. This would be a disaster

for the economy, as the amount of workers increases or decreases, so does GDP per

capita. There is no other choice than to raise innovative policies in order to increase

the labor force contributing to economic growth.

22

6 Appendices

Appendix 1

Table 6.1; Descriptive Statistics for the 60 richest countries.

Variable LNGDP_PER_CAP LNK_PER_CAP LNL_PER_CAP DEP LIFE_EXP

Mean 0.26647 0.36477 0.058305 -0.053151 72.09644

Median 0.228955 0.237404 0.051518 -0.054936 72.86341

Maximum 0.916231 1.400571 0.181712 0.089747 80.50146

Minimum -0.006063 -0.286055 -0.064307 -0.184071 43.10071

Std. Dev. 0.182275 0.338615 0.048243 0.061196 6.916645

Observations 52 52 52 52 52

23

Appendix 2

Table 6.2; Regression results for the 60 richest countries.

Dependent Variable: LNGDP_PER_CAP

Method: Least Squares

Date: 05/06/11 Time: 13:39

Sample: 1 60

Included observations: 52

Variable Coefficient Std. Error t-Statistic Prob.

C 1.012343 0.221444 4.571555 0.0000

LNK_PER_CAP 0.133299 0.058241 2.288735 0.0266

LNL_PER_CAP -0.710825 0.440162 -1.614917 0.1130

DEP -1.161887 0.384933 -3.018409 0.0041

LIFE_EXP -0.011302 0.002960 -3.818502 0.0004

R-squared 0.536025 Mean dependent var 0.266470

Adjusted R-squared 0.496538 S.D. dependent var 0.182275

S.E. of regression 0.129333 Akaike info criterion -1.161638

Sum squared resid 0.786173 Schwarz criterion -0.974018

Log likelihood 35.20258 Hannan-Quinn criter. -1.089709

F-statistic 13.57464 Durbin-Watson stat 2.198067

Prob(F-statistic) 0.000000

Table 6.3; Correlations between the variables.

Correlations

lny lnk lnl dep life

Pearson

Correlation

lny 1.000 .351 .026 -.542 -.557

lnk .351 1.000 -.188 -.194 .030

lnl .026 -.188 1.000 -.444 -.209

dep -.542 -.194 -.444 1.000 .445

life -.557 .030 -.209 .445 1.000

Sig. (1-tailed) lny . .005 .428 .000 .000

lnk .005 . .091 .084 .416

lnl .428 .091 . .000 .068

dep .000 .084 .000 . .000

life .000 .416 .068 .000 .

24

Appendix 3

Figures 6.1; Scatter Plots.

25

Appendix 4

Figures 6.2; Population Pyramids.

Source: National Institute of Population and Social Security Research, 2010

26

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